Fixed-Income Securities Chapter 10 Fixed-Income Securities

What Are Bonds? Liabilities, or “publicly traded IOUs” Also called “fixed income securities” since payments are fixed amounts Borrower agrees to pay a fixed amount of interest over a specified period of time Borrower agrees to repay a fixed amount of principal at a predetermined maturity date

Why Invest in Bonds? They can provide current income for conservative investors At times, they can provide capital gains (or losses) for more aggressive investors Some bonds can provide tax-free income They can be used for preservation and long-term accumulation of capital

Interest Rates and Bonds The behavior of interest rates is the single most important force in the bond market Interest rates and bond prices move in opposite directions When interest rates rise, bond prices fall When interest rates drop, bond prices move up Bond markets are bullish when interest rates are low or falling Bond markets are bearish when interest rates are high or rising

Figure 10.1 Behavior of Interest Rates Over Time (1962–2011) (Source: Aswath Damodaran, The Data Page, http://pages.stern.nyu.edu/~adamodar/.)

Bonds Versus Stocks Compared to stocks, bonds offer lower returns Main benefits of bonds in portfolio: Lower risk and level of stability High levels of current income Diversification Bonds add an element of stability to a portfolio

Figure 10.2 Comparative Performance of Stocks and Bonds (1992-2011)

Bonds and Risk Interest Rate Risk is the chance that changes in interest rates will affect the bond’s value Purchasing Power Risk is the chance that bond yields will lag behind inflation rates Business/Financial Risk is the chance the issuer of the bond will default on interest and/or principal payments Liquidity Risk is the risk that a bond will be difficult to sell at a reasonable price Call Risk is the risk that a bond will be “called” (retired) before its scheduled maturity date

Essential Features of a Bond Coupon is the amount of annual interest income Current Yield is a measure of the annual interest income a bond provides relative to its current market price Principal (par value) is the amount of capital that must be repaid at maturity Maturity Date is the date when a bond matures and the principal must be repaid Term Bond is a bond that has a single maturity date Serial Bond is a bond that has a series of different maturity dates Note is a debt security originally issued with a maturity from 2 to 10 years

Principles of Bond Price Behavior Price of a bond is a function of its coupon rate, its maturity, and market movements in interest rates Longer maturities move more with changes in interest rates Premium bond has a market value that is above par value Occur when market interest rates are below bond’s coupon rate Discount bond has a market value that is below par value Occur when market interest rates are above bond’s coupon rate

Figure 10.3 The Price Behavior of a Bond

Essential Features of a Bond (cont’d) Call feature allows the issuer to repurchase the bonds before the maturity date Freely callable Noncallable Deferred call Call premium is the amount added to bond’s par value and paid upon call to compensate bondholders Call price is the bond’s par value plus call premium Refunding provision prohibits the premature retirement of an issue from proceeds of a lower-coupon refunding bond

Essential Features of a Bond (cont’d) Sinking fund stipulates how a bond will be paid off over time Applies only to term bonds Issuer is obligated to pay off the bond systematically over time

Types of Secured Debt Secured debt is backed by pledged collateral Senior bonds are backed by legal claim to specific assets Mortgage bonds are backed by real estate. Collateral trust bonds are backed by securities (stocks, bonds) held in trust by a third party Equipment trust certificates are backed by specific pieces of equipment, such as railcars or airplanes

Types of Unsecured Debt Unsecured debt is backed only by the promise of the company to pay Junior bonds are backed only by promise and good faith of the issuer to pay Debenture is an unsecured (junior) bond Subordinated debentures are unsecured bonds whose claim is secondary to other claims Income bond requires interest to be paid only after a specific amount of income has been earned

Bond Ratings Bond ratings are letter grades that designate investment quality Private bond rating agencies assign ratings based upon financial analysis of the bond issuer Investment grade ratings are received by financially strong companies Junk bond ratings are received by companies making payments, but default risk is high Split ratings occur when a bond issue is given different ratings by major rating agencies Higher rated bonds have less default risk and pay lower interest rates

Table 10.2 Bond Ratings

The Market for Debt Securities Bonds are traded mainly over the counter Bond price activity is remarkably stable compared to stock market Bond market is larger than the U.S. stock market Bond market is growing rapidly

Treasury Bonds Considered risk free—no risk of default Interest is exempt from state and local taxes Sold in $1,000 denominations Types of Treasury Bonds Treasury notes: maturities of 2, 3, 5, 7, and 10 years Treasury bonds: mature in 30 years Treasury Inflation-Indexed Obligations (TIPS) Protect against inflation by adjusting investor returns Interest rates are very low Maturities of 5, 10, and 20 years

Municipal Bonds Interest is tax-exempt for Federal taxes Interest can be tax-exempt from state taxes if you live in the state where the bond was issued

Which Bond to Choose? You are choosing between two bonds. Bond A is a corporate bond and has an 8% yield Bond B is a state bond from a state you live in and has an 5% yield. You are in a 25% tax bracket. Would you rather have 8% or 7.01%?

Corporate Bonds Issued by corporations from four major segments Industrials Public utilities Rail and transportation bonds Financial issues Provide higher returns than government bonds due to higher risk of default Wide variety of bond quality and bond types available

Zero-Coupon Bonds Do not pay interest Sold at deep discount from par value Value increases over time Subject to tremendous price volatility as interest rates fluctuate Interest must be reported as it is accrued for tax purposes, even though no interest is actually received. Treasury strips are zero-coupon bonds created from U.S. Treasury securities.

Mortgage-Backed Securities Bond backed by pool of residential mortgages Principal and interest are paid monthly Governmental agencies are major issuers: Government National Mortgage Association (GNMA) Federal Home Loan Mortgage Corporation (FHLMC) Federal National Mortgage Association (FNMA) Self-liquidating investment since portion of principal is received each month

Collateralized Mortgage Securities Mortgage-back bond pool that is divided into “tranches,” or classes of investors All principal payments go first to the shortest tranche until it is fully retired, then the next in sequence is paid Allows investors to choose short-term, medium-term or long-term investment Potentially complex; interest rate fluctuations may have significant impact upon bond prices

Asset-Backed Securities Issued by corporations and backed by pools of loans Auto loans Credit card loans Home equity loans Provide relatively high yields Short maturities, typically 3 to 5 years Interest and principal payments are monthly High credit quality

Junk Bonds (High-Yield Bonds) Highly speculative, usually subordinated debentures Have low, sub-investment grade ratings Typically offer very high yields Prices tend to behave more like stocks than bonds

Global Bonds Potentially higher returns than U.S. bonds Offer broader diversification opportunities Interest rate trends in other countries may not follow U.S. rates Currency exchange rate fluctuations can impact returns in U.S. dollars

Dollar-Denominated Bonds Bonds issued by foreign governments or corporations and denominated in dollars Based on U.S. dollars Yankee bonds are registered with the SEC and issued and traded in U.S. Eurodollar bonds are not registered with the SEC and are issued and traded outside of the U.S. No currency exchange rate risk since bonds are in U.S. dollars

Foreign-Pay Bonds Bonds issued by foreign governments or corporations Based on currency other than U.S. dollars Not registered with the SEC and issued and traded outside of the U.S. Subject to currency exchange rate risk

Convertible Securities Fixed-income security that allows holder to convert the security into a specified number of shares of the issuing company’s common stock Two major types of convertible securities: Convertible bonds Convertible preferred stock “Equity kicker”: another name for the conversion feature that allows holder to convert the security into a specified number of shares of common stock Forced conversion: calling in of convertible bonds by the issuing firm

Convertible Securities (cont’d) Conversion privilege: the conditions and specific nature of the conversion feature on convertible securities Conversion period: the time period during which a convertible issue can be converted Conversion ratio: the number of shares of common stock into which a convertible issue can be converted Conversion price: the stated price per share at which common stock will be delivered to the investor in exchange for a convertible issue

Sources of Value Value of convertibles is based in both the stock and the bond dimensions of the security Convertibles trade much like common stock as the market price of the stock starts getting close to (or exceeds) the stated conversion price Convertibles trade much like a bond when the market price of the stock is well below the conversion price Bond price sets a “price floor” in case the stock price goes into a freefall

Measuring the Value of a Convertible Conversion Value: indication of what a convertible issue would trade for if it were priced to sell on the basis of its stock value

Measuring the Value of a Convertible (cont’d) Conversion Equivalent: the price at which the common stock would have to sell in order to make the convertible security worth its present market price

Measuring the Value of a Convertible (cont’d) Conversion Premium: amount above the conversion value that investors are willing to pay; typically due to the higher current income provided by convertibles over common stock

Measuring the Value of a Convertible (cont’d) Payback Period: the length of time it takes for the buyer of a convertible to recover the conversion premium from the extra current income earned on the convertible